1 New Developments in Credit Portfolio Management and Basel II: A New Paradigm: “Underwrite & Distribute” Michel Crouhy PRMIA New York, September 26, 2005

2 Bank Loan Portfolios Banks originate and hold loan exposures that are a function of their geography and industry expertise. As a result, they hold concentrated credit risk. Credit portfolios have become increasingly more concentrated in less creditworthy obligors. This situation has made banks more vulnerable in economic downturns ( ): –Disintermediation of banks that started in the 70s continues today: IG firms are less likely to borrow from banks –Regulatory rules induce banks to extend credit to lower-credit quality obligors.

3 Transformation of Credit Business A New “Securities” Model For Credit Change: Increase balance sheet turnover ORIGINATE & HOLD UNDERWRITE & DISTRIBUTE

4 Changes in the Approach to Credit TraditionalPorfolio-Based Credit Function Approach Investment strategyOriginate and Hold Underwrite and Distribute Ownership of the creditBusiness Unit Portfolio Management assets or Business Unit / Portfolio Mgmt Risk measurement Use notional value Use risk based capital of the loan Model only losses Model losses due to default due to default and risk migration (MTM) Risk ManagementUse a binary approvalApply risk return process at origination decision making process Basis for compensationVolume Risk-Adjusted Performance for loan origination PricingGridRisk Contribution

5 Originate to Sell Model Capital and Risk Committee  Policy setting  Limit setting  Risk reporting Client Coverage Origination/ Underwriting Syndication / Distribution Credit Portfolio Mgt Risk Evaluation  Quantification of risk (EL, capital)  Model selection / validation Asset Sales & Trading Monitoring & Review Product Structuring/ Securitization Servicing ISSUERS&BORROWERSISSUERS&BORROWERS B A N K S & I N V E S T O R S

6 Credit Portfolio Management Credit Portfolio Group Credit Portfolio Management Counterparty Exposure Management Credit Portfolio Solutions  Increases the velocity of capital  Reduces concentration and event risk  Increase return on economic capital  Responsible for financials, but not a profit center _________________________________________  Hedges and trades retained Credit Portfolio  Houses “public-side” Research Analysts, Portfolio Managers, Traders __________________________________________  Manages market risk of derivatives counterparty exposure _________________________________________  Provides advice to originators on structuring and credit risk mitigation

7 Four Primary Portfolio Actions 1.Distribute loans through primary syndication to desired hold level 2.Reduce loan exposures by selling down, securitizing or hedging concentrated loan positions with credit default swaps 3.Focus first on high risk obligors, particularly those that are leveraged in market value terms and experience high volatility of returns 4.Simultaneously, sell or hedge low risk, low return loan assets

8 Adopting Credit Asset Management Strategies Portfolio Strategies that focus on adding credit exposures are Emerging within banks in two ways: Credit Asset Management Designing cash and synthetic portfolios of credit risk purchased and managed on a leveraged and unlevered basis with access to all credit asset classes selecting best relative value investments with a long term investment horizon Credit Trading / Relative Value Acquiring and trading synthetic credit portfolios by selling protection on a leveraged basis with access primarily to investment grade credit default swaps selecting the best relative value trades with a short term trading horizon

9 Credit Asset Management Strategies Investing In Credit (cont’d) Leverage 5 – 12 xLeverage 3 – 6 x Credit RiskCredit Risk / Interest Rate RiskCredit Risk / Interest Rate Risk / Liquidity Risk / Mark-to-market Cash Flow CDOs “Asset Backed Securities” Market Value CDOs “Hedge Fund” Loans Combinations High Yield Bonds Private Equity Hedge Funds Emerging Markets Others CLOs Balance Sheet CDOs Guaranteed Principal CLOs Arbitrage CLOs Loans/HY CBOs HY CDOs Emerging Mkt CFOs Fund of Hedge Funds Risk Return Legal Maturity 10 – 15 years / Expected Life 6 – 8 years Legal Maturity and Expected Life 5 – 7 years Source: RMF Investment Products Research

10 Basel II  Basel II and Active Portfolio Management require the same: Historical data to calibrate key inputs, i.e., PDs, LGDs, EADs. IT infrastructure.  But, there are additional, though necessary, costs: Upgrading the rating systems: more granularity, two-tier rating system; Backtesting discipline: Keep the history of not only past ratings and LGDs, but also of all the relevant information to reconstitute them.

11 Basel II  Basel II is one step behind what is required for active credit portfolio management: Credit portfolio models (internal models): Which rating philosophy? Point-in-Time (PIT) vs. Through-the-Cycle (TTC) Capture portfolio effects Incorporate risk mitigation techniques and hedging strategies Provide opportunities for capital reduction through a better risk assessment Economic capital attribution: still, regulatory arbitrage opportunities will persist with Basel II Deal analyzer and pricing models

12 Economic Capital EL: Expected Loss (average probability of default X loan amount at default) UL: Unexpected Loss (1 standard deviation in value) Capital: A loss amount determined by the probability of default of the lender